Chapter 2 a further look at financial statements

A Further Look at
Financial Statements

Chapter
2-2 Financial Accounting, Fifth Edition

Study Objectives
Study Objectives

1. Identify the sections of a classified balance sheet.
2. Identify and compute ratios for analyzing a company’s
profitability.
3. Explain the relationship between a retained earnings
statement and a statement of stockholders’ equity.
4. Identify and compute ratios for analyzing a company’s
liquidity and solvency using a balance sheet.
5. Use the statement of cash flows to evaluate solvency.
6. Explain the meaning of generally accepted accounting
principles.
7. Discuss financial reporting concepts.
Chapter
2-3

 Wednesday – Classified Balance Sheet

 Friday – Ratios/Rules/Principles

 Monday – Review Chapter 2

 Wednesday February 3rd – Possible Test over
Chapters 1 and 2

Chapter
2-4

A Further Look At Financial Statements
A Further Look At Financial Statements

The Classified Using the Financial Financial Reporting
Balance Sheet Statements Concepts

Current assets Ratio analysis The standard-setting
Long-term Using the income environment
investments statement Characteristics of
Property, plant, and Using the statement of useful information
equipment stockholders’ equity Assumptions and
Intangible assets Using a classified principles
Current liabilities balance sheet Constraints
Long-term liabilities Using the statement of
cash flows
Stockholders’ equity

Chapter
2-5

The Classified Balance Sheet

Presents a snapshot at a point in time.

To improve understanding, companies group
similar assets and similar liabilities together.

Standard Classifications
Illustration 2-1

Assets Liabilities and Owner’s Equity
Current assets Current liabilities
Long-term investments Long-term liabilities
Property, plant, and equipment Stockholders’ equity
Intangible assets

Chapter
2-6 SO 1 Identify the sections of a classified balance sheet.


Illustration 2-2

Chapter
2-7


Illustration 2-2

Chapter
2-8


Current Assets

Assets that a company expects to convert to
cash or use up within one year or the operating
cycle, whichever is longer.

Operating cycle is the average time it takes from
the purchase of inventory to the collection of
cash from customers.

Chapter


Current Assets
Illustration 2-3

Companies usually list current asset accounts in the order
they expect to convert them into cash.
Chapter


Review Question
Cash, and other resources that are reasonably
expected to be realized in cash or sold or consumed
in the business within one year or the operating
cycle, are called:
a. Current assets.
b. Intangible assets.
c. Long-term investments.
d. Property, plant, and equipment.

Chapter

 Page 78 - BE 2-2

Chapter
2-12


Long-Term Investments
Investments in stocks and bonds of other companies.

Investments in long-term assets such as land or
buildings that a company is not currently using in its
operating activities.
Illustration 2-4

Chapter


Property, Plant, and Equipment
Long useful lives.

Currently used in operations.

Depreciation - allocating the cost of assets to a
number of years.

Accumulated depreciation - total amount of
depreciation expensed thus far in the asset’s life.

Chapter


Property, Plant, and Equipment
Illustration 2-5

Chapter


Intangible Assets
Assets that do not have physical substance.
Illustration 2-6

Chapter


Review Question
Patents and copyrights are
a. Current assets.
b. Intangible assets.
c. Long-term investments.
d. Property, plant, and equipment.

Chapter


Current Liabilities
Obligations the company is to pay within the
coming year.

Usually list notes payable first, followed by
accounts payable. Other items follow in order of
magnitude.

Also….current maturities of long term debt.

Liquidity - ability to pay obligations expected to
be due within the next year.
Chapter


Current Liabilities
Illustration 2-7

Chapter


Long-Term Liabilities

Obligations a company expects to pay after one
year.
Illustration 2-8

Chapter


Review Question
Which of the following is not a long-term liability?
a. Bonds payable
b. Current maturities of long-term obligations
c. Long-term notes payable
d. Mortgages payable

Chapter


Stockholders’ Equity
Illustration 2-2

Common stock - investments of assets into the business by the
stockholders.

Retained earnings - income retained for use in the business.

Chapter

 Let’s try it…

 Page 82 - Exercise 2-5

Chapter
2-23

Using the Financial Statements

Ratio Analysis
Expresses relationship among selected items of
financial statement data.

Relationship expressed in terms of either a
percentage, a rate, or a simple proportion.

Chapter
2-24


Illustration: Best Buy has current assets of $9,081 million
and current liabilities of $6,301 million. We can determine
a relationship between these accounts by dividing current
assets by current liabilities, to get 1.44. The alternative
means of expression are:

Percentage: Current assets are 144% of current
liabilities.
Rate: Current assets are 1.44 times as great as
current liabilities.
Proportion: The relationship of current assets to current
liabilities is 1.44:1.
Chapter
2-25


Chapter
2-26


Using the Income Statement
Illustration 2-10

Circuit City reported a net loss of $10.2 million for the year ended Feb. 28, 2007.

Chapter
2-27 SO 2 Identify and compute ratios for analyzing a company’s profitability.


Review Question
The balance in retained earnings is not affected by:
a. net income
b. net loss
c. issuance of common stock
d. dividends

Chapter SO 3 Explain the relationship between a retained earnings
2-28


Using a Classified Balance Sheet
Liquidity—the ability to pay obligations expected to
become due within the next year or operating cycle.
Illustration 2-14

When working capital is positive, there is greater likelihood
that the company will pay its liabilities.

Best Buy had working capital in 2007 of $2,780 million.

Chapter SO 4 Identify and compute ratios for analyzing a company’s
2-29

Liquidity
Using the Financial Statements Ratio

Liquidity ratios measure the short-term ability of the
company to pay its maturing obligations and to meet
unexpected needs for cash. Illustration 2-15

$9,081 $7,985
= 1.44:1 = 1.32:1
$6,301 $6,056

1.68:1 1.75:1

1.21:1 NA

For every dollar of current liabilities, Best Buy has $1.44 of current assets
2-30


Using a Classified Balance Sheet
Solvency—the ability to pay interest as it comes due and
to repay the balance of a debt due at its maturity.
Solvency ratios measure the ability of the company to
survive over a long period of time.

2-32

Solvency

Debt to total assets ratio measures the percentage of
total financing provided by creditors rather than
stockholders. Illustration 2-16

$7,369 $6,607
= 54% = 56%
$13,570 $11,864

55% 52%

21% NA

The 2007 ratio means that every dollar of assets was financed by 54 cents of debt.
2-33


Review Question
The following ratios are available for Leer Inc. and Stable Inc.

Compared to Stable Inc., Leer Inc. has:
a. higher liquidity, higher solvency, and higher profitability.
b. lower liquidity, higher solvency, and higher profitability.
c. higher liquidity, lower solvency, and higher profitability.
d. higher liquidity and lower solvency, but profitability cannot be
compared based on information provided.
2-34


Using the Statement of Cash Flows
To aid in the analysis of cash, the statement of cash flows
reports the cash effects of
1. a company’s operating activities,
2. its investing activities, and
3. its financing activities.

Chapter
2-36 SO 5 Use the statement of cash flows to evaluate solvency.

Illustration 2-17

Using the
Statement
of Cash
Flows
Would you feel ( ) ( )

better about a
company’s health if
you knew that most
of its cash was
generated by
operating its
business rather than
by borrowing cash
from lenders?
Chapter
2-37
SO 5 Use the statement of cash flows to evaluate solvency.

Cash provided by operating activities fails to
take into account that a company must invest
in new PP&E and must maintain dividends at
current levels to satisfy investors.

Chapter Answers on notes page.
2-38 SO 5 Use the statement of cash flows to evaluate solvency.

Financial Reports Concepts

The Standard-Setting Environment
Generally Accepted Accounting Principles (GAAP) - A set
of rules and practices, having substantial authoritative
support, that the accounting profession recognizes as a
general guide for financial reporting purposes.

Various standard-setting bodies determine these guidelines:
 Securities and Exchange Commission (SEC)
 Public Company Accounting Oversight Board (PCAOB)
 Financial Accounting Standards Board (FASB)
 International Accounting Standards Board (IASB)

Chapter
2-39 SO 6 Explain the meaning of generally accepted accounting principles.


Review Question
Generally accepted accounting principles are:
a. a set of standards and rules that are recognized
as a general guide for financial reporting.
b. usually established by the Internal Revenue
Service.
c. the guidelines used to resolve ethical dilemmas.
d. fundamental truths that can be derived from
the laws of nature.

Chapter
2-40 SO 6 Explain the meaning of generally accepted accounting principles.


Characteristics of Useful Information
Illustration 2-18

Chapter
2-42 SO 7 Discuss financial reporting concepts.

Assumptions in Financial Reporting
Illustration 2-19

Monetary Unit Economic Entity

Time Period Going Concern

Chapter


Principles in Financial Reporting
Illustration 2-20

Cost
Full Disclosure

Chapter


Constraints in Financial Reporting
Illustration 2-20

Materiality Conservatism

Chapter


1. Ability to easily evaluate one company’s results Comparability
relative to another’s.
2. Belief that a company will continue to operate for Going concern
the foreseeable future.
3. The judgment concerning whether an item is large Materiality
enough to matter to decision makers.
Chapter


4. The reporting of all information that would make a
Full disclosure
difference to financial statement users.
5. The practice of preparing financial statements at Time period
regular intervals.
6. The quality of information that indicates the
Relevance
information makes a difference in a decision.
Chapter


7. A belief that items should be reported on the
Cost
balance sheet at the price that was paid to acquire
the item.
8. A company’s use of the same accounting principles Consistency
and methods from year to year.
9. The use of accounting methods that do not Conservatism
overstate assets or income.
Chapter


10.Tracing accounting events to particular companies. Economic entity
11.The desire to minimize errors and bias in financial Reliability

12.Reporting only those things that can be measured in Monetary unit

Chapter


Review Question
What is the primary criterion by which accounting
information can be judged?
a. Consistency.
b. Predictive value.
c. Usefulness for decision making.
d. Comparability.

Chapter

Copyright
Copyright

Copyright © 2009 John Wiley & Sons, Inc. All rights reserved.
Reproduction or translation of this work beyond that permitted
in Section 117 of the 1976 United States Copyright Act
without the express written permission of the copyright owner
is unlawful. Request for further information should be
addressed to the Permissions Department, John Wiley & Sons,
Inc. The purchaser may make back-up copies for his/her own
use only and not for distribution or resale. The Publisher
assumes no responsibility for errors, omissions, or damages,
caused by the use of these programs or from the use of the
information contained herein.

Chapter
2-52

Profitability

Illustration: Earnings per share (EPS) measures the net
income earned on each share of common stock.
Best Buy

Illustration 2-11

$1,377 - $0 $1,140 - $0
= =
(481 + 485) 2 (485 + 493) 2
Chapter
2-53 $2.85 $2.33

Illustration 2-13

Using the
Using the
Financial
Financial
Statements
Statements

Using a
Classified
Balance Sheet

Chapter
2-54


Using the Statement of Stockholders’ Equity
Observations from this financial statement of Best Buy:
 Common stock increased during the first year as the
result of issuance of common stock.
 Common stock declined in the second and third years as
the result of repurchasing shares of stock.
 Best Buy paid an increasing amount of dividends each
year.
 Prior to 2003, Best Buy did not pay dividends, even
though it was profitable and could do so.
Why didn’t Best Buy pay dividends prior to 2003?
Chapter
2-55


Review Question
For 2010 Stoneland Corporation reported net
income $26,000; net sales $400,000; and average
shares outstanding 6,000. There were preferred
stock dividends of $2,000. What was the 2010
earnings per share?
a. $4.00
$26,000 - $2,000
b. $0.06 = $4.00
6,000
c. $16.67
d. $66.67
Chapter
2-56 SO 2 Identify and compute ratios for analyzing a company’s profitability.

Using the Statement of Stockholders’ Equity
Illustration 2-12

Most companies
use a statement of
stockholders’
equity, rather than
a retained earnings
statement, so that
they can report all
changes in
stockholders’
equity accounts.

Chapter SO 3 Explain the relationship between a retained earnings
2-57

Chapter 2 a further look at financial statements

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